Inflation refers to the decrease in a currency’s purchasing power. It can come as a result of various factors. Inflation isn’t necessarily a bad thing, as it can also accompany positive changes. However, it usually has adverse effects on businesses and individuals. Inflation risk, also known as purchasing power risk, exists for all companies that suffer from inflation.
What is Inflation Risk?
Inflation risk refers to the uncertainties or hazards involving inflation. For companies, it refers to the risk that inflation may occur and accompany adverse impacts. Inflation risk represents how changes in prices of goods and services can affect a company’s operations negatively. Similarly, it may refer to the decrease in purchasing power more than expected by a company.
Inflation risk also exists for investors. In that context, it refers to the risk that inflation will undermine an investment’s performance. Usually, investors want to get returns above the inflation rate that occurs. Therefore, they take inflation into account when making decisions about their portfolios. If the cash flows from an investment are lower than the inflation rate, then investors have to suffer.
How does Inflation Risk work?
When investors invest in security, they will expect a specific amount of return. For example, when investing in bonds, investors can expect a fixed-income. These investments may be short- or long-term. While inflation risk may exist for short-term investments, it does not have a significant impact. For long-term investments, inflation risk may have a substantial effect.
Investors that invest in long-term securities want the returns from them to exceed the inflation rate. For fixed-rate returns, inflation rates will have a significant impact on the returns. However, the same is not the case for securities that account for inflation, for example, inflation-rate or floating-rate bonds. In these cases, the inflation risk will be minimal or at least lower than for fixed-rate securities.
Why is Inflation Risk crucial?
Inflation risk is crucial for investors as it dictates the returns they receive and expect. As mentioned, inflation risk has more impact on long-term investments compared to short-term ones. Similarly, it will affect fixed-rate investors more. Since more inflation means these investors will get lower returns, inflation risk is crucial for them.
If investors fail to consider the impact of inflation on their investments, they can suffer considerably. Due to the decrease in purchasing power, investors receive returns that have a lower value. That is despite receiving the same amount over the period. Inflation risk will always exist in any economy. Therefore, investors need to consider it when making investment decisions.
Similarly, inflation risk doesn’t only encompass the risk of inflation occurring. It is the risk that the inflation rate is higher than what investors anticipated. Since investors need to adjust for inflation beforehand, any difference between their estimate and actual inflation can also be critical. Overall, inflation risk plays a significant role in investments and the returns that investors get.
Inflation risk is the risk that inflation may bring about adverse change with it. Similarly, it represents the risk that inflation occurs at a higher rate than anticipated. Inflation risk is crucial for both businesses and investors. Since inflation causes a decrease in a currency’s purchasing power, inflation risk can affect long-term profitability.